What Impact Will Inflation Have on Your Retirement?

Americans are worried about what inflation might do to their retirement finances.

The Allianz Life 2016 Inflation Study was conducted in March of 2016 that looked at Americans’ perceptions of inflation and was conducted with 1,005 U.S. adults age 18 and older.

The study revealed 47% reported being “very concerned” about the rising cost of living and how it will impact their retirement plans. While 36% were either “very worried” or “panicked” that they won’t be able to afford the lifestyle they have come to enjoy due to rising costs.

Inflation over the Years

According to InflationData.com, inflation has been relatively low over the past 2 ½ decades. It averaged slightly over 3% in the 1990s and 2 ½% in the 2000s. Inflation has been under 2% in the current decade. Inflation has averaged 4.1% over the past 50 years, which underscores how low it has been recently.

Given these recent numbers, it is remarkable that more than a third of respondents believe the cost of living will increase 3%-4% per year during their retirement. About 19% expect to see an annual increase of 5%-6%. Whether you believe these perceptions are valid or not, an upcoming retiree should be concerned about inflation. Even relatively low inflation will more than double the cost of goods & services during the average life expectancy of a healthy 65-year old couple. Fixed income investments are not likely to produce a return that is high enough to permit adequate withdrawals and keep pace with inflation.

Tips to Prepare for Inflation in Retirement

Start by maximizing your Social Security. Social Security has its own financial problems and the system will need to be changed in some way to remain solvent. However, changes are more likely to impact younger workers. It is unlikely that those entering retirement in the next five years will see changes to their benefits. Social Security has an automatic cost-of-living adjustment built in. Retirement plans should examine the best way to maximize Social Security benefits to get the most from this inflation fighting feature.

The best way to prepare for inflation in retirement is to build a substantial savings and keep a sufficient percentage of your assets in equities to fight inflation. While equities have historically shown more volatility (the largest ups and downs) than fixed income, they also have historically fared well in relation to inflation.

Jeremy Siegel’s book Stocks for the Long Run has long been considered somewhat of a “bible” for investors and has recently been updated to include the Great Panic of 2008. The book examines the returns of different types of assets going back to 1802. He adjusts the return of each type of asset to factor out inflation and shows the net return. These inflation-adjusted figures are also known as ‘real returns’.

Siegel concluded that over the 210 years, the real return of a broadly diversified stock portfolio has averaged 6.6% a year. In other words, a diversified stock portfolio beat inflation by 6.6% per year. That would have resulted in the doubling of one’s purchasing power about every decade for the past two centuries.

This doesn’t mean all of a retiree’s investments should be in stocks. Establish an asset allocation strategy that allows you to take advantage of the volatility in the financial markets without affecting your retirement income. A proper asset allocation should include equities, fixed income, and cash.

Diversify the equity portion of the allocation between growth and value stocks, domestic and foreign, and small and large companies to increase the probability that at least part of your portfolio is performing well. Use your asset allocation strategy to determine where to draw income from in order to maintain balance. In years when the stock market is going up, your income will come from stocks. When the market is doing poorly the fixed income assets will provide your income. Remember that diversification does not ensure a profit or protect against loss and it is still possible to lose money.

The final key to financial security in retirement is to carefully monitor and control spending. You need a financial strategy that is flexible enough to adapt to a person’s changing needs and circumstances. Inflation can be detrimental to one’s retirement finances, but carefully managing your money throughout your golden years can help counter inflation’s impact.

Select a withdrawal rate that can be sustained over a long period of time. Research on a sustainable withdrawal rate suggests that a 4 to 4 ½% distribution can be maintained and increased each year with inflation. We suggest the distribution rate be established at no more than 4% to start. This dollar amount may need to be reduced if the rate exceeds 6% in a down market. Setting the amount at 4% or below allows for principal volatility without the need to frequently change distribution amounts.

In years the market performs poorly you may not want to take a cost-of-living increase. We also recommend delaying large purchases such as a car replacement until a good market provides excess earnings.

The future is uncertain and future retirees should be concerned about inflation. Planning helps prepare for uncertainty. You should always seek the advice of a competent retirement planner to review your plan before retiring.

Rick’s Tips:

A recent study reported 47% of pre-retirees were “very concerned” about the rising cost of living on their retirement plans.

Social Security has an automatic cost-of-living adjustment built in to the benefit.

A diversified stock portfolio beat inflation by 6.6% per year over the past 210 years according to Jeremy Siegel’s research.